Risk management: Hedge funds take stress test

“We’re seeing a growing number of hedge fund managers look at stress testing, in addition to VaR [value at risk], as part of their risk management,” says Lance Smith, CEO of Imagine Software, a software developer for investment management solutions. “The limitations of VaR have become more obvious in the light of some extreme market events such as [hedge fund] Amaranth’s blow-up.”

Smith continues: “VaR looks at historical correlation of risk factors, which is essentially a type of average. But in calculating risk in the event of an extreme situation, stress testing is more appropriate. VaR is expressed as a multiple of a typical daily movement. You can estimate the daily volatility of returns and then, if you see frequent P&L swings greater than that, you know there is something awry in the portfolio. It’s a good calculation of likely events. But...